Inverted hockey stick method quantifies price uncertainty in petroleum investment evaluation
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abstract
In this paper, we present a new method for quantifying the uncertainty of economic projections due to uncertainty in future oil prices. Traditionally, the petroleum industry has employed what are known as "hockey stick price forecasts, i.e., monotonically increasing price profiles, in economic calculations to evaluate investment opportunities. Calculations are often run using most-likely, optimistic, and pessimistic price profiles in an attempt to quantify the uncertainty in the resulting economic indicators. These conventional hockey stick methods significantly underestimate uncertainty because they do not reproduce the volatility inherent in oil prices. Stochastic methods that attempt to model price volatility have been used successfully and indicate that there is considerably more uncertainty in oil and gas development projects than has been previously recognized. However, many operators do not use stochastic methods for modeling oil prices, most likely because they require more time and effort to implement than conventional methods. The Inverted Hockey Stick method presented herein is similar to conventional methods in that only three price realizations are run to quantify uncertainty. However, the high and low cases are designed to better capture the range of possible future price paths. Uncertainty ranges for economic indicators predicted by the new method are comparable to 70-95% probability ranges predicted by the stochastic bootstrap method, significantly greater than the 32-42% ranges predicted by conventional methods. This new method can be easily incorporated into existing economic modeling systems. Recognition of the greater uncertainty in oil and gas investment opportunities, both upside as well as downside, should improve investment decision making.
